Supreme Court says no to federal jurisdiction in short-selling spat

May 16, 2016

The U.S. Supreme Court building

The U.S. Supreme Court building

The U.S. Supreme Court has held that a lawsuit alleging a group of securities brokerages violated New Jersey anti-racketeering and common law by making unauthorized short sales belongs in state court, saying the dispute does not “arise under” federal securities law.
The high court’s decision affirms a 2014 decision by the 3rd U.S. Circuit Court of Appeals that reversed a lower court’s ruling and sent the case back to the New Jersey Superior Court where the plaintiff investors originally filed it in 2012. Manning v. Merrill Lynch Pierce Fenner & Smith Inc., 772 F.3d 158 (3d Cir. 2014).

The Supreme Court held that the test to determine whether a suit is properly brought in federal court pursuant to Section 27 of the Securities Exchange Act, 15 U.S.C.A. § 78aa, is the same as the test under 28 U.S.C.A. § 1331, which requires that a lawsuit “arise” under federal law.
While Section 27 gives federal courts exclusive jurisdiction over suits “brought to enforce any liability or duty created by” the Exchange Act, Section 1331 provides general federal jurisdiction to “all civil actions arising under” federal law.
“Section 27 provides exclusive federal jurisdiction of the same class of cases as ‘arise under’ the Exchange Act for purposes of §1331,” Justice Elena Kagan said in the majority opinion. “The text of Section 27, most naturally read, supports that rule.”
Chief Justice John Roberts, Justices Samuel Alito, Stephen Breyer, Ruth Bader Ginsburg, and Anthony Kennedy joined in the majority.
In a concurring opinion, Justice Clarence Thomas, joined by Justice Sonia Sotomayor, said Section 27’s language bars the suit from federal court and does not require the majority’s additional interpretation of Section 1331’s “arise under” language.
Jonathan Richman, co-head of the securities litigation group at Proskauer, said the ruling clarifies the jurisdictional tests.
“The court’s decision clarifies that the jurisdictional tests under Section 27 of the Exchange Act and under the general federal-question statute are the same — and that both are subject to familiar ‘arising under’ principles,” he said.
Richman was not affiliated with the case.
Regulation SHO
In 2012 shareholders of Escala Group, a global federation of companies in the collectibles market, sued Merrill Lynch Inc., Knight Capital Americas, UBS Securities, E-Trade Capital Markets, National Financial Services and Citadel Derivatives Group in New Jersey state court, alleging the brokerages illegally engaged in “naked” short-selling of Escala shares.
Short-selling is an investment strategy that bets a company’s share price will drop. The short seller borrows securities of the targeted company and sells them on the open market, profiting on the anticipated price change.
In a “naked short,” the seller does not borrow the securities in time to actually deliver them to a buyer.
The shareholders claim the brokerages knowingly diluted Escala’s stock value by short-selling it without intending to own or borrow shares, allegedly in violation of New Jersey’s anti-racketeering statute and common law.
The complaint does not allege a violation of Regulation SHO, 17 C.F.R. § 242.200 — a Securities and Exchange Commission rule governing short-selling under the Exchange Act — but refers to it frequently.
Jurisdictional fight
The brokerages removed the suit to the U.S. District Court for the District of New Jersey under 28 U.S.C. §§ 1331 and 1337, which provide federal jurisdiction to lawsuits involving a federal question.
The plaintiffs asked U.S. District Judge Jose Linares to remand the suit to state court, but he declined, finding federal courts have jurisdiction under Section 27. Manning v. Merrill Lynch, No. 12-cv-4466, 2013 WL 1164838 (D.N.J. 2013).
The shareholders appealed to the 3rd Circuit, which reversed Judge Linares’ decision and remanded the case.
The appeals panel first held that the court did not have jurisdiction under Section 1331 and then it determined that Section 27 also cannot confer federal jurisdiction.
The brokerages appealed, arguing that the 3rd Circuit did not correctly apply Section 27 because the suit seeks to enforce Regulation SHO duties.
Exchange Act Section 27
Because the 3rd U.S. Circuit Court of Appeals held that Section 1331 does not confer federal jurisdiction, the Supreme Court determined that Section 27 also does not confer federal jurisdiction.
“The 3rd Circuit found that … all [the complaint’s] claims sought relief under state law and none necessarily raised a federal issue,” Justice Kagan noted. “Merrill Lynch did not challenge that ruling, and we therefore take it as a given.”
“Construing Section 27, consistent with both text and precedent, to cover suits that arise under the Exchange Act serves the goals we have consistently underscored in interpreting jurisdictional statutes,” Justice Kagan said.
“Out of respect for state courts, this court has time and again declined to construe federal jurisdictional statutes more expansively than their language, most fairly read, requires,” she added.
In his concurring opinion, Justice Thomas said Section 27 “does not use the phrase ‘arising under’ or provide a sound basis for adopting the arising-under standard.”
In a statement, Bank of America spokesman Lawrence Grayson said, “We believe that the underlying lawsuit is without merit and we will defend against the substantive allegations in state court, where we already have filed for dismissal.” Bank of America is Merrill Lynch’s parent company.
Brendan S. Maher of Stris & Maher LLP, who served as counsel of record for the investors, said in a statement the decision is a win for states’ rights.
“This decision vindicates the right of states and their courts to hold financial bad actors accountable under their own laws. Federalism lives, and rightly so,” Maher said.